Why Chip-Equipment Makers Have Hope

January 29, 2002

On Jan. 15 Intel (INTC) dropped a silicon bombshell when it announced plans to cut capital spending by 25% in 2002. The drop from $7.3 billion in 2001 to $5.5 billion in 2002 sounded like a disaster for Applied Materials (AMAT) and a host of other companies that make advanced equipment used to manufacture silicon chips -- and that rely on Intel for sales. Chipmaking gear accounts for half of Intel's total budget.

Worse, the Santa Clara (Calif.) giant was hardly alone in trimming outlays. Other big chipmakers including Samsung Electronics and Taiwan Semiconductor Manufacturing (TSMC) also announced in January that they would cut their 2002 capital spending.

No surprise then that in the past week, the stocks of semiconductor equipment makers have swooned. Applied Materials, the largest company in this sector, saw its shares slide from $44.70 to around $41.50 on Jan. 29.

PLAYING CATCH-UP? However, this could actually be a buying opportunity for intrepid investors. Here's why. Intel and a few other industry heavyweights accelerated their spending last year, buying new chipmaking gear that costs less to run and builds better chips. Now, to remain competitive, the rest of the industry might have to spend more on similar gear in 2002 or risk getting clobbered by Intel in price wars in 2003, when a chip recovery is expected to materialize.

Chipmakers playing catchup with Intel could more than compensate for the giant's tightened purse strings. All told, it might mean things won't be as bad as they seem for Applied Materials and other makers of latest-generation chip-manufacturing equipment.

A number of ongoing technological shifts will drive chipmakers to upgrade their equipment in the coming year. One is the move to bigger silicon wafers. Intel and other semiconductor makers cut these wafers into smaller pieces that later are turned into finished chips. The newest equipment allows the chipmakers to use 300-millimeter wafers rather than 200 millimeters. That means they can make nearly 50% more chips for nearly the same cost.

MORE CHIPS PER WAFER. Another major trend favors gear that packs more transistors onto each chip. The latest equipment allows chipmakers to etch transistors only 0.13 microns apart. That's one-thousandth the diameter of a human hair and is nearly 28% better than the previous generation of chip-burning gear. More transistors per chip means more chips can be cut from the same wafer. And that allows chips to pack more computing power per square millimeter.

Reaping the benefits of that technology, Intel last year dropped its manufacturing costs as much as 40% below those of rivals using older gear. That's the main reason behind the company's 9% capital spending bump in 2001, vs. the rest of the industry's 34% cut, according to Hans Mosesmann, an analyst with Prudential Financial.

The upgrade cycle has indeed already started, as no one wants to get caught with older manufacturing gear if the chip sector rebounds in 2003. Intel's chief competitor, Advanced Micro Devices (AMD) has announced that it will increase its capital spending by 20% this year, to $850 million. Much of that money will go toward the kind of new equipment that Intel already has.

NO CHOICE. Other small to midsize chipmakers will likely follow suit. Last year, they spent 50% of their capital budgets on next-generation equipment, and this year they'll spend as much as 70% on it, says Len Jelinek, an analyst with semiconductor consultancy iSuppli. "They don't have a choice," he says.

The upshot? The sector will have a difficult 2002, for sure, but perhaps not as tough as many analysts had originally forecast. Sales could be off by only 10%, vs. previous forecasts of 30%, some analysts believe.

Interested investors might have to move fast, though. Investment bank J.P. Morgan upgraded a host of semiconductor equipment makers on Jan. 23. And since the end of September, the average stock in the sector has appreciated by 60%. That could limit further upside potential. Indeed, some analysts even say these stocks are as much as 50% overvalued.

However, if more companies think like AMD and spending forecasts such as Jelinek's prove accurate, the chip-equipment makers could survive Intel's bombshell without too much worry. By Olga Kharif in Portland, Ore.